What moves the yield curve? lessons from an affine term structure model for Chile

Abstract

This paper attempts to provide an economic interpretation of the factors that drive the movements of interest rates of bonds of different maturities in a continuous-time no-arbitrage term structure model. The dynamics of yields in the model are explained by two latent factors, the instantaneous short rate and its time-varying central tendency. The model estimates suggest that the short end of the yield curve is mainly driven by changes in first latent factor, while longterm interest rates are mainly explained by the second latent factor. Consequently, when thinking about movements in the term structure one should think of at least two forces that hit the economy; temporary shocks that change short-term and medium-term interest rates by much larger amounts than long-term interest rates, causing changes in the slope of the yield curve; and long-lived innovations which have persistent effects on the level of the yield curve.